Trade credit is a type of financing that allows businesses to purchase goods or services now and pay for them later. You can use this short-term financing to smooth out your cash flow or take advantage of early payment discounts.
This can be an attractive option for companies that don't have the cash on hand to make a purchase. Or, if you're selling, it can help you close a deal by giving your customer more time to pay.
The purpose of this article is to provide an introduction to trade credit and its role in business.
Applying for a Business Loan is another alternative!
What Is Trade Credit?
It is a business financing alternative.
In a trade credit transaction, one party (the creditor) agrees to extend credit to another party (the debtor) in exchange for goods or services.
In other words, it's an arrangement between 2 businesses that allow the customer to get products without making payment immediately but at a later date
How Does Trade Credit Work?
The supplier records each transaction under a trade credit on an invoice.
The buyer must sign the invoice so that there is proof of receipt.
Both the buyer and seller should record the transaction in their accounting records.
The supplier could also send an IOU or promissory note with an order.
A seller who wants a firm commitment before shipping goods may require a commercial draft. They will send this to the buyer's bank with the invoice.
The bank will have the buyer sign the draft before turning over the invoice, at which time the selling firm will ship the goods.
In most cases, the buyer has anywhere from a week to 6 months to pay the invoice.
Some suppliers may offer a credit period longer than six months.
Typically, a supplier won't charge interest rates
on a trade credit agreement, though it's not unheard of. A business can qualify for a discount on the total amount if it pays the invoice in a short amount of time.
Understanding Trade Credit Terms
Suppliers usually record the terms of this type of business financing in the following manner:
(discount) / (discount period), net (credit period)
For example, a seller might offer terms of "2/7, net 30."
- The "2" represents the amount of discount available.
- The "7" shows when the buyer must pay the invoice to get the discount.
- And the "net 30" indicates the amount of time offered to pay the invoice (usually in days).
If the supplier doesn't offer a discount, the terms will just say "net 60."
Trade Credit Example
Let's say a restaurant uses a trade credit to purchase ingredients.
The invoice is $5,000, and the terms are 3/10, net 60.
The restaurant has 2 months to pay the invoice. If it settles in less than 10 days, it receives a 3% discount.
On a $5,000 invoice, the 3% discount is $150.
If the business chooses to pay within 10 days, they'd only pay $4,850.
If they pay on a later day, they "lose" the $150 discount and pay for the total amount, $5,000.
Pros And Cons Of Trade Credit
- Convenient financing. Trade credit allows businesses to finance purchases without going through a traditional lending process. This can save time and money.
- Builds business relationships. Arranging trade credit with suppliers can help build strong business relationships. This can lead to better terms and pricing on future orders.
- Increases buying power. Trade credit gives businesses additional buying power, which can be helpful when trying to negotiate better deals with suppliers.
Some disadvantages are:
- High-interest rates. While not common, some sellers might impose interest rates, which can add to the cost of purchases.
- Difficult to qualify. Not all businesses will qualify for trade credit, which may only be for a limited amount.
- Requires careful management. This includes making timely payments and maintaining a good relationship with suppliers. Otherwise, businesses could find themselves unable to get future financing.
Some advantages are:
- Helps close sales. Offering trade credit can help close deals, as some customers may only purchase if they can finance the purchase over time.
- Increases customer loyalty. Customers who take advantage of trade credit often feel more loyal to the seller, as they have an ongoing financial relationship. This can lead to repeat business and referrals.
- Builds good will. Sometimes, offering trade credit can simply build good will with customers. This could lead to future business opportunities down the road.
- Extended terms can be risky. When businesses extend terms to customers, they essentially give them a loan. This can be risky, as there's no guarantee the customer will pay back the debt.
- High bad debt expenses. Customers not repaying their debts can eat into business profits and hinder cash flow.
- Requires careful management. Sellers need to manage trade credit relationships carefully. This includes regularly assessing the creditworthiness of customers and maintaining accurate records.
Trade Credit How-To Guide
How To Obtain Trade Credit As A Buyer
To obtain trade credit from a supplier, you must establish a good relationship with the supplier and have a good credit history
Once you have established credit with a supplier, you will likely be able to obtain trade credit on favorable terms, such as low-interest rates (if applicable), discounts, or even flexible repayment terms.
While most suppliers do offer this service, don't take it as a given. Ask your supplier.
The supplier may also require you to purchase a certain minimum amount of goods or services before they extend credit to you.
When asking for trade credit, ask to speak to the owner or whoever is in charge of credit and financing.
Receiving trade credit is a benefit the seller could take away at any moment. Make sure always to honor the agreement, so this doesn't happen.
If you don't have a relationship with the seller, you might still be able to get trade credit. There will be extra steps you need to complete, though.
Before granting a trade credit, the supplier might ask for:
- Credit reports. These consist of both personal and business credit scores.
- Financial documents. Suppliers may want to see a business's balance sheet, income statement, and cash flow statement.
- Payment history. If you have a good payment history with the vendor, it is more likely to extend a line of credit.
- Business plan.
Remember that getting a trade credit isn't guaranteed.
If you need extra capital to buy goods for your business, another great alternative could be a microloan.
Apply For A Microloan!
How To Offer Trade Credit As A Supplier Or Seller
If your business supplies other businesses, you can offer trade credit to increase sales. This increases sales because it makes it easier for buyers to purchase your goods or services.
To offer trade credit, you may require that buyers purchase a certain amount of goods or services before you extend credit to them.
To incentivize sales with trade credit, offer competitive terms and an early payment discount.
If you do decide to set up trade credits, remember that the business-to-business device is primarily an advantage to the buyer.
A business could choose to pay early, which means you would lose some revenue. Or it could not pay at all, leading to a loss.
When you offer trade credit to a particular client, you'll want to evaluate payment history, financial documents, and credit reports.
How To Choose Which Clients To Offer Trade Credit To
You should complete a credit analysis for all potential new clients.
This will give you an idea of whether or not they will likely repay their obligations.
Several factors go into this analysis, including the client's:
- financial stability
- payment history with other suppliers
- industry and the current economic conditions therein
Usually, if they have an established credit history, they are probably worthy of receiving trade credit.
You should also consider your company's ability to absorb losses should the client default.
Once you understand the risks involved, you can make an informed decision about whether or not to extend trade credit.
If you decide to offer credit, set clear terms and conditions and put them in writing. This will help avoid any misunderstandings down the road.
How To Set A Credit Period As A Seller
The period that a business can extend trade credit to its customers has the name "credit period." You, the supplier, set the credit period, which can be anywhere from 30 days to 120 days.
A business may offer different credit periods to different customers based on factors such as the amount of business the customer does with the supplier or whether the customer pays their bills on time.
The credit period begins on the invoice date and ends on the date that payment is due. If you don't receive payment by the due date, the customer "defaulted" on their payments and may be subject to late fees or other penalties.
How Does Accounting Work With Trade Credit?
To record a trade credit transaction, the creditor must first set up an account with the debtor. This account will track the amount of credit extended, as well as the payments made by the debtor.
The creditor will then record the transaction in their books, using the trade credit account as a liability.
As the debtor makes payments on the account, the creditor will record these payments in their books as well. When the debtor pays off the entire account balance, the creditor will close the trade credit account.
To account for trade credit, businesses will use one of two methods:
- Accrual method. Companies record revenue when they make the sale, even if the customer has not yet paid for the purchase. The business will then record the trade credit as an "accounts receivable" on its balance sheet.
- Cash method. Businesses do not record revenue until the customer actually pays for the purchase, not when they originally made the sale.
AP Turnover Ratio
When managing their trade credit, one of the critical indicators businesses should be aware of is their Accounts Payable (AP) turnover ratio.
This metric measures how quickly a company pays its invoices and can provide valuable insights into a business's financial health and performance.
Ideally, businesses should aim for a high AP turnover ratio, which means they are efficiently managing their trade credit and cash flow.
On the other hand, a low AP turnover ratio could indicate that a company is struggling to pay its bills on time.
There are several ways to calculate an AP turnover ratio, but the most common method is to divide a company's total annual sales by its average accounts payable balance.
Common Phrases Used In Trade Credit
There are a few terms used in trade credit agreements. Some of these terms include:
- Minimum purchase. This is the minimum amount of merchandise a customer must purchase to qualify for trade credit.
- Discount period. This is the period when a customer can take advantage of early payment discounts.
- Grace period. This is the period after the due date when a customer can still make payment without being delinquent. Grace periods typically range from 10 to 15 days.
- Credit rating. This is a measure of a customer's creditworthiness or ability to repay their debts. Customers with a high credit rating are lower risk and may receive more favorable terms, such as a longer credit period.
- Tradeline. This records a customer's credit history with a particular supplier. Other suppliers can use trade lines to assess a customer's creditworthiness.
- Buyer's credit. This is a type of trade credit used to finance the purchase of goods from overseas suppliers. Buyer's credit is typically offered at a lower interest rate than other types of financing, making it an attractive option for businesses that import goods.
- Accounts receivable. They are the money that customers owe to a company for the purchase of its goods or services. Accounts receivable is an asset on a company's balance sheet because it represents money the business will receive in the future.
Alternatives To Trade Credit
Trade credit is just one way to finance your business. Here are some other alternatives to trade credit:
- Business microloans. Small business loans can be a great option if you need a lump sum of cash to finance your business.
- Business lines of credit. A business line of credit is similar to a credit card because you're given a credit limit that you can draw from as needed. This can be a great option if you need flexibility in using the funds.
- Business credit cards. Business credit cards can be a great way to finance your business expenses. Many business credit cards offer rewards or cash back on purchases, which can be an excellent way to save money on business expenses.
- Invoice financing. Invoice financing is a type of short-term loan based on your outstanding invoices. This can be a great option if you need cash flow assistance and have customers who are slow to pay their invoices.
- Equipment financing. Equipment financing can be a great option if you need to purchase new machinery for your business. With equipment financing, you make monthly payments, and the lender owns the equipment until you pay it off.
What's The Best Solution For You?
Trade credit can be a helpful tool for businesses of all sizes. It can help companies to save on interest costs, and it can also help them build up a good payment history with their creditors.
However, it is essential to remember that trade credit is a debt. Businesses should only extend credit to customers they are confident will be able to repay.
Whether you're a buyer that needs capital to finance the purchase of goods, or a seller needing a cash flow boost while you wait for customers to pay, a microloan could be what you need.
At Camino Financial, we offer several commercial funding options that could help you. Our loan application process
is easy, quick, and 100% online.
Whatever your financial needs, we promise "No Business Left Behind."
What are the most common trade credit terms?
The most common trade credit terms are net 30, net 60, net 90, and net 120. This means the buyer has 30, 60, 90, or 120 days to pay their invoice, respectively.
The chosen trade credit usually depends on the industry, the buyer's credit rating, or both.
What type of credit is trade credit?
Trade credit is a type of business credit. Business credit is different from personal credit in that it depends on the creditworthiness of your business rather than your personal credit score.
This means that even if you have bad personal credit, you may still be able to get trade credit from suppliers.
What are the types of trade credit?
There are two types of trade credit:
- Open account trade credit: used for short-term transactions.
- Installment account trade credit: used for larger purchases that the buyer pays off over time.
Is trade credit expensive?
No, trade credit is not expensive. It is often cheaper than other forms of financing, such as loans. This is because suppliers are typically willing to offer discounts for early payment, and most don't charge interest rates.
What is the net method for trade credit accounting with discounts?
The net method is the most common way to account for trade credit with discounts. This method involves recording the invoice at the total amount and then recording a separate entry for the discount when the buyer pays the invoice.
Discounts could also require accounts receivable write-offs.
What is trade credit insurance?
It is insurance that protects businesses from non-payment by customers. This type of insurance can cover both domestic and international receivables.
What are credit put options for trade credit?
A credit put option is another type of trade credit insurance that protects businesses from customer non-payment.
What are trade credit services?
Trade credit services are companies that help businesses manage their trade credit risk. These services can provide businesses with information on customers, help businesses screen new customers, and provide insurance for receivables.
Is trade credit a loan?
Trade credit is simply an agreement between a buyer and a seller that allows the buyer to delay payment for goods or services.
While it's not technically a financing product, some consider it an interest-free loan.
What is better, trade credit or immediate payment?
As with most things in business, the answer to this question is "it depends." The best type of credit for your company will depend on various factors, including the size of your business, industry, and specific needs.
That said, if you need goods or services quickly and cannot afford to wait for payment, then paying upfront may be the better option.
Ultimately, the decision of whether to use trade credit or immediate payment is a decision that you should make on a case-by-case basis. There is no one-size-fits-all answer to this question.